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This paper shows that countries characterized by a financial accelerator mechanism may reverse the usual finding of the literature — flexible exchange rate regimes do a worse job of insulating open economies from external shocks. I obtain this result with a calibrated small open economy model that endogenizes foreign interest rates by linking them to the banking sector's financial leverage. This relationship renders exchange rate policy more important compared to the usual exogeneity assumption. I find empirical support for this prediction using the Local Projections method. Finally, 2nd order approximation to the model finds larger welfare losses under flexible exchange rate regimes.

In the late 90's, emerging market countries have faced severe financial crises, resulting in large costs of bank restructuring, extended periods of contraction, and high unemployment. Theoretical and empirical studies have blamed the inability of pegged regimes to withstand speculative attacks, especially with rapidly growing international financial activity during this period. Advocates of this view have advised a combination of flexible exchange rate regimes and inflation targeting. Despite these developments, many researchers have shown that emerging market economies do not de facto float their currency (e.g. Calvo and Reinhart, 2002, Levy-Yeyati and Sturzenegger, 2005, Alesina and Wagner, 2006 and Bersch and Klüh, 2007). Among the reasons are the lack of central bank credibility, large terms of trade shocks, high inflation due to exchange rate pass through, and liability dollarization. The interaction of liability dollarization with exchange rate regimes, and the implications for output volatility have been analyzed extensively by the “Balance Sheet Effects” literature (e.g. Allen et al., 2002, Berganza et al., 2004, Calvo, 2001, Cespedes et al., 2004, Chang and Velasco, 2000a, Chang and Velasco, 2000b, Chang and Velasco, 2001, Choi and Cook, 2004, Eichengreen and Hausmann, 2007, Gatti et al., 2007, Krugman, 1999 and Schneider and Tornell, 2004). In this literature, the effects of exchange rates regimes on the economy are determined by two main opposing effects. On one hand, smaller exchange rate volatility limits the fluctuations of the net foreign liability component of balance sheets, thereby reducing uncertainty and risk premiums in an economy with high degree of liability dollarization. On the other hand, a tight exchange rate regime results in involuntary interest rate adjustments in response to foreign interest rate shocks. These so-called external constraints on monetary policy are less binding under more flexible regimes where a part of the external shock is absorbed by exchange rates. A majority of the literature finds that the latter effect dominates the former and flexible exchange rates do a better job of insulating economies from external shocks. This paper compares the relative strength of the aforementioned two effects by measuring the performance of different exchange rate regimes. It formulates a small open economy dynamic stochastic general equilibrium (DSGE) model where terms of foreign credit depends on the balance sheet of domestic banks, and there is a financial accelerator mechanism. The financial accelerator framework of Bernanke et al. (1999) (BGG) is a convenient starting point for the purposes mentioned above for two reasons. First, it allows for the effects of various shocks to be amplified through its effects on firms' balance sheets, which in turn provides a better fit of the model's output to the actual data. Second, the model includes a domestic financial sector which facilitates the analysis of balance sheet effects and foreign creditor behavior when the contract between the domestic banking system and the foreign creditors is defined. Gertler et al. (2007) (GGN) extend this model to a small open economy setting and show how the central bank has to peg the interest rates to the foreign interest rates under a fixed regime, and thereby cause a hike in real interest rates in response to adverse external shocks. The recession caused by these shocks is less profound under flexible exchange rate regimes where a part of the negative effect of the external shock is absorbed by the depreciation of the currency. Furthermore, this contrast between the performances of different exchange rate regimes becomes more apparent when the financial accelerator mechanism is included due to its implicit amplification mechanism. Analysis in this paper alters the standard financial accelerator framework in two ways. First, domestic banks are only able to diversify the idiosyncratic shocks but are vulnerable to systematic ones. This is in contrast to the standard model where the banks are able to diversify the aggregate risk and always collect the market rate of return by integrating the shock into an ex-post contract with the firm. This alteration provides a better representation of the actual functioning of the market and also allows banks' net worth to fluctuate over time, which in turn has a crucial effect on the foreign interest rate premium and output volatility.1Second, instead of assuming foreign interest rate premiums are purely exogenous (as in the standard model), the role of the foreign sector is defined more rigorously by deriving the relationship between the domestic banks' balance sheet positions and the interest rate charged on loans by foreign creditors. As a result, foreign interest rate premium is derived endogenously, and it is governed by a financial accelerator mechanism similar to the one between the domestic banks and the firms. In particular, the contract between domestic banks and foreign creditors is such that if the banks become more leveraged, interest rates charged by foreign creditors increase. Moreover, the assumption of 100% foreign currency denominated debt renders central bank exchange rate policy more important since exchange rate fluctuations have a direct impact on the translational exposure of the domestic banks, and thus on foreign interest rates in this setting. Impulse responses obtained from a calibrated and log-linearized model show, contrary to the majority of the literature that foreign interest rate shocks and technology shocks lead to greater output volatility under flexible exchange rate regimes when a country risk premium mechanism is included in the model. The results exhibit how economies become highly leveraged when asset prices increase, and how price fluctuations increase (decrease) the amplitude of output response under flexible (fixed) regimes.2 It is important to point out that the analysis is based on a non-crisis framework since the linearization technique employed is not suitable to capture the dynamics governing crisis periods. Therefore, the results do not suggest the superiority of pegged regimes. A better interpretation would be that for countries in need of foreign finance to develop, a stable domestic financial market is essential, and that a pure float exchange rate regime is not appropriate in this setting. Razin and Rubinstein (2006) provide empirical evidence for this finding by showing that fixed exchange rate regimes perform better when the probability of a crisis is low. First order approximation methods are not capable of capturing the effect of risk on the behavior of agents. Hence, a welfare analysis with unconditional moments is conducted using the second order approximation algorithm of Schmitt-Grohe and Uribe (2004) to measure the significance of a country risk premium on the economy. The results are in line with those of the first order approximation findings, and show that fixed exchange rate regimes reduce; flexible exchange rate regimes increase welfare costs when a country risk premium is included. Therefore, the risk premium constitutes an automatic stabilizer under fixed exchange rate regimes as it dampens the effect of the initial shock. Welfare effects are also measured using conditional moments since unconditional computations do not account for the welfare effects during the transition period from one steady state to another. Results are similar. Finally, the paper investigates if there is an empirical support for the theoretical results using the Local Projections method formulated by Jorda (2005) to obtaining impulse responses. In contrast to the literature, I include Emerging Market Bond Indices (EMBI) instead of average advanced country lending rates as a proxy for foreign interest rates. Results show that output responses to external shocks are smaller with relatively fixed exchange rate regimes. The goal in this paper is to analyze emerging economies' experience with exchange rate regimes. Therefore, I use three assumptions to distinguish between an emerging and an advanced economy — aside from the small open economy framework. First, I assume that the model economy is unable to borrow abroad in terms of the domestic currency — concept known as “Original Sin” in the literature (e.g. Burger and Warnock, 2006 and Hausmann and Panizza, 2003). Second, the financial friction parameters are calibrated to emerging markets so that the effects of external shocks create higher response than in more developed economies with better institutions. Third, I assume that the banking system is more domestically-oriented and is unable to generate funds from its foreign offices in response to liquidity crunches. Cetorelli and Goldberg (2008) show that financial globalization enables banks in U.S. to move funds across borders and avoid liquidity shortages in response to monetary policy shocks. The remainder of the paper is organized as follows. Section 2 explains the model. Section 3 describes the effects of the financial accelerator mechanism and different exchange rate regimes, defines the foreign sector and the contract with the domestic banks, and discusses the simulation results. Section 4 outlines the methodology and reports the output of the welfare analysis. Section 5 reports the empirical findings. Section 6 concludes.

Recent empirical and theoretical literature on emerging markets has favored flexible exchange rate regimes considering the vulnerability of fixed regimes to speculative attacks. Despite this fact, countries have been observed to control their exchange rate fluctuations. This paper has shown one reason for this so-called “Fear of Floating” or “Hidden Pegs” as it links the banking system's balance sheets to the country risk premium. The paper finds that in the absence of a financial crisis, exchange rate regimes that limit the effect of external and technology shocks on balance sheets perform better in terms of limiting output volatility when the economy is unable to borrow in terms of its own currency. It is important to note, however that the results of the paper do not necessarily favor fixed exchange rate regimes, but rather should be seen as a case against perfectly flexible exchange rate regimes in a majority of emerging market countries. The analysis suggests that countries with shallow financial markets that have significant foreign exchange exposure should limit exchange rate fluctuations until their markets are developed enough to sustain a flexible regime. In this respect, it would be interesting to investigate how exchange rate regimes interact with the level of financial development to determine the vulnerability of these economies to external and domestic shocks.